ASC 842, Leases – ASU 2021-09 Provides Additional Guidance on Use of Risk-Free Rate and Required Disclosures for Non-Public Entities

As the deadline to implement the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 842 quickly approaches for private companies and not-for-profits, the FASB published a tapered amendment to the previously issued guidance.

The amendment could have a minor impact on private and non-for-profit entities; however, it may ease lease accounting rules for these entities by enabling lessees to have a more flexible way to elect a discount rate to measure leases at the present value on the balance sheet.  It also may have a favorable impact on entities that were electing to apply the risk-free rate as an accounting policy over all leases.

On February 25, 2016, the FASB issued Accounting Standards Update No. 2016- 02, Leases (Topic 842), to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing transactions. The Board has made efforts in assisting stakeholders by creating a post-implementation review of Topic 842 to help field questions and feedback surrounding potential implementation issues experienced while implementing Topic 842. The Board has also hosted two public round tables to solicit feedback from stakeholders. This update stems from some private company stakeholders indicating that there could be significant costs and complexities that come along with implementing the new standard primarily related to the practical expedient that allows the use of a risk-free discount rate as an accounting policy election for non-public entities. 

To understand the new Update, there are several factors that need to be considered including what stakeholders are impacted by the Update, what the main provisions are and why they are an improvement from the current Generally Accepted Accounting Principles (GAAP), when will the amendments be effective, and what are the transition requirements for early adopters and private/non-for-profit entities that will be adopting Topic 842 for the fiscal years beginning after December 15, 2021. 

The main stakeholders impacted by ASU 2021-09 include non-public business entities including all not-for-profit entities and employee benefit plans. 

Under Topic 842, private companies and not-for-profit entities have an opportunity to elect a practical expedient to use a risk-free rate to discount lease payments rather than using an incremental borrowing rate. The use of the risk-free rate had to be implemented as an accounting policy across all asset classes.  ASU 2021-09 allows lessees to make the determination of which asset classes to apply the risk-free rate and no longer requires entities to use this as an overarching approach over all asset classes. The entity must disclose which asset classes the risk-free rate election was made. Additionally, the FASB clarified in the recent Update that the rate implicit in the lease when it is readily determinable must be used to discount future lease payments instead of a risk-free or incremental borrowing rate. 

The effective date for early adopters and those entities that have not yet adopted Topic 842 as of November 11th, 2021 will differ. Entities, that have not adopted Topic 842 as of November 11th, are required to adopt the risk-free rate update at the same time as the initial adoption of Topic 842. 

For entities that were early adopters of Topic 842 as of November 11, 2021, the amendments are effective for the fiscal year ending after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022. These entities are required to apply the amendments on a modified retrospective basis to leases that exist at the beginning of the fiscal year of adoption of a final Update. The adoption of the Update should not be treated as an event that would reallocate or remeasure the contract consideration or adjust the lease term or classification. 

As you might imagine, the use of the risk-free rate for specific asset classes rather than adopting for all leases as an accounting policy may be a beneficial option for private and not-for profit entities. Prior to this Update, entities that chose to elect the practical expedient to use the risk-free-rate across all asset classes faced several challenges including (1) the risk-free rate election raises the likelihood that the present value of the lease payments and any residual value guaranteed by the lease would equal or exceed the fair value of the leased asset, potentially resulting in a classification of the lease as a finance lease and potentially leading to a day-one impairment charge and (2) the use of a lower rate would increase the initial measurement of a lessee’s lease liability and right-of-use asset.

 Overall, the recently issued ASU will grant private and not-for-profit entities more flexibility in utilizing the risk-free -rate by asset class when applicable. There will be additional disclosures required to note which asset classes the risk-free -rate was used for; however, the newly issued Update provides more clarity and could potentially ease implementation of Topic 842 for private and not-for-profit entities in the upcoming year. 

ASU 2021-09 Use of Risk-Free Rate and Required Disclosures guidance at a glance

• Entities impacted include non-public business entities including all not-for-profit entities and employee benefit plans
• Lessees now can elect the use of the risk-free rate on an asset class basis rather than taking an overarching approach over all asset classes
• Asset classes where risk-free rate election was made must be disclosed
• If readily available, the rate implicit in the lease is still required to be used to discount future lease payments
• Entities that have not adopted Topic 842 as of November 11th, are required to adopt ASU 2021-09 at the same time as the initial adoption of Topic 842
• ASU 2021-09 is effective for early adopters for the fiscal year ending after December 15, 2021, and interim periods within fiscal years beginning after December 15, 2022 on a modified retrospective approach
• For early adopters, the modified retrospective application of ASU 2021-09 should not be treated as an event that would reallocate or remeasure the contract consideration or adjust the lease term or classification

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